The book where I first read the phrase “Cop Logic” is lost to memory, but the concept stuck. A modern form of Occam’s Razor, the process of cop logic states that when uncovering the violent death of a housewife in her home, and finding out that the ne’er do well husband is missing, it doesn’t make any sense to think up any scenarios beyond the husband’s guilt until he is found and questioned. Process must still be followed, but experience dictates a 95% probability the husband did it, and its best not to get distracted until that possibility is investigated.
I want to thank mining and energy analysts for so clearly supporting the application of cop logic to investing for 2012. For eight years, analysts in the resource sector have, correctly for much of the period, touted Chinese industrial demand for the “tree grows to the sky” supercycle in their sector. Over the past two weeks, however, Chinese demand as a catalyst for investment has all but disappeared in favor of potential supply disruption – geopolitical concerns in Libya and Iran for oil, labor disruptions in South America for copper. To see this as a bad sign we only have to remember what happens on Criminal Minds when the defendant is forced by new information to change their alibi.
Cop logic clearly implies slower global economic growth for 2012. It is entirely probable that the European Union may be saved by ECB intervention, but I would not hazard a guess on this either way. What is evident, however, is that even if the Eurozone is preserved, massive austerity for southern Europe will be a precondition for the rescue effort. For investors there appears only two potential outcomes – a horrendous structural implosion or a preservation strategy for the current system that all-but guarantees painful economic reforms and deep recessions for Italy, Spain, and other member nations. Cop logic says rising GDP growth for Europe as a whole is simply not in the cards without divine intervention.
Trade data, while notoriously inaccurate*, indicate that the Eurozone and the U.S. are roughly equal in size as destinations for Chinese exports. A significant decline in European economic activity clearly implies a headwind for 2012 Chinese economic growth. Economists will correctly point out that China’s economy is less export-driven than most believe, much more sensitive to infrastructure and real estate development. Unfortunately, as professor Chovanec details HERE, the Chinese real estate bubble us currently imploding, taking the balance sheets of a number of regional governments with it.
Cop logic also has implications for Q4 corporate capex although here there may be a silver lining. As Oracle’s recent results indicate, global CFOs responded to the potential for a European economic disaster by suspending capital expenditure. This only makes sense – investing in expansion is risky enough with a strong global backdrop. Earnings season for Q4 is likely to uncover a significant drop in corporate spending across the globe, which will affect revenues for large swaths of the S&P 500, most notably in technology, media and industrials. However, this trend could be temporary and stock sell-offs in these sectors could provide buying opportunities as conditions stabilize.
The sell-side bias towards optimism makes it easy to predict a wholesale attempt at obfuscation for 2012, giving us page after page of reasons why companies are likely to “side-step” a global economic slowdown. As we can see above, the process has already started for resource stocks as the bullish rationale adapts to a new economic reality. We will be given ample reason to invest further in cyclical stocks despite the fact that slower global growth almost by definition ends the possibility of relative outperformance. For this reason, cop logic will be instrumental for investors this year.
*It is one thing that Apple products are considered imports from China – they are assembled there – although the profit stays in Cupertino. But the calculation of the value of exports is archaic. Boxes of, for instance, Windows 7.0 OS disks, are valued at something like $20 per pound at the shipyard.